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Save yourself from the temptation

By Tensing Rodrigues

You must have heard of the Franklin Templeton Debt Funds debacle. The debate is still on as to who is to be blamed. I am not sure if anyone is to be blamed at all.  Among us there is an old saying, If good happens the credit goes to the bride and groom, if bad happens the blame goes to the matchmaker. So let us keep clear of the blame game as not only is it futile but it is positively harmful. Because then the whole focus of the debate is on finding the culprit and we evade solving the problem and protecting ourselves from its consequences.

Let us briefly introduce the gist of the FT Debt Fund problem. Sometime in mid-April, FT announced the winding up of six of its debt funds, which means one cannot invest in them and take money out of them in any manner. This was done because their NAV was crashing on account of huge redemptions in the face of falling bond prices since the lockdown began.

This does not mean that the investors will lose their entire money. It also does not mean that they will not lose any money. According to FT, about four per cent of the money could be available in three months’ time, about 20 per cent in six months’ time, about 26 per cent in one year and about 46 per cent in two years. That’s about it: in two year’s time investors may be able to get back a little less than half of their investment; the rest may take longer; or may be lost. 

Now what is the whole problem about? The debt funds invest in the debt securities (bonds) issued by companies. Some may invest in the debt securities issued by the government but that is a different ball game. The bonds carry a fixed rate of interest and mature in a fixed time. At maturity the funds get the maturity proceeds along with the interest. Which means the fund cannot get the money out of the bonds or invest further in them. But bonds are tradable so the fund can sell the bonds in the market and get the money out and invest further in them by buying them from the market. 

The price of the bonds is fixed in the market by the demand and supply. The price of a given bond depends upon the interest that it pays as compared with the interest paid by another bond. The price also depends on the risk that the bond may fail to pay the interest or to repay the principal. The return from a bond is otherwise fairly low. But a fund can deliver a better return by playing with the risk of the bond. It can buy a risky bond at a cheap price and then sell it when it rises for some reason. But this requires a smart and continuous play buying and selling. This is exactly what FT did, and managed to deliver a better than normal return on these six debt funds.

  But with the industry going into tailspin after the Covid-19 threat and the lockdown,  and companies buckling under the crisis the chances of default by the companies kept increasing. The bonds fast became scrap and the hopes of a recovery waned. The bond prices crashed. The Debt Scheme NAVs crashed. Panicked, the investors tried to stop loss by redeeming. FT was forced to sell bonds for dirt cheap prices. So it tried to avert the total crash by freezing the sales and purchases waiting to redeem when the bonds mature. Of course, even that was fraught with risk. What if the companies cannot
pay back?

The purpose of this post-mortem is not to enlighten you on the FT Debt Schemes debacle. It is to help you understand that all that looks safe may not be safe. We have a general misconception that debt is safer that equity. That fixed income securities are safer than the shares. That is not always true. It may be true if you are looking at buying a bond and waiting till its maturity. But if you are looking at return through the market, it is far more risky than equity. The stock market too crashed. But what is the loss till now? And what could it be in a two years’ time? Your loss in the FT Debt Funds could be much as 50 per cent in that time horizon.

The author is an investment consultant.
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tenala@gmail.com

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